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Dangers Lurk in Exchange-Traded Notes

Investors who buy ETNs enter into an uneven relationship with more sophisticated counterparties who are very willing to take advantage.

Samuel Lee, 06/11/2012

This article originally appeared in the June/July 2012 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000. 

The decision to invest in an exchange-traded note seems to depend on a straightforward calculus, the trade-off between credit risk and the ETN’s tracking and tax benefits. Unlike an exchange-traded fund, an ETN is essentially an uncollateralized loan given by an investor to an investment bank, with all the risks that entails. In return, the bank promises exposure to an index’s return, minus fees, regardless of how hard it is to actually own the index’s underlying assets. On top of that, many (but not all) ETNs are taxed like stocks, thanks to a quirk in U.S. tax law. These benefits could be a godsend for investors who want entry into less-liquid, tax-unfriendly strategies. As long as investors keep their eyes on credit risk, they can have their cake and eat it, too. At least, that’s the conventional wisdom.

It’s wrong.

ETNs are so much more dangerous than that. They are one of the easiest ways individual investors and advisors unwittingly enter into adversarial relationships with vastly more-sophisticated investment banks. Unlike mutual funds and most ETFs, ETNs are not registered under the Investment Company Act of 1940, which obliges funds to have a board of directors with fiduciary responsibility and to standardize their disclosures. ETNs, on the other hand, are weakly standardized contracts, presumably between two sophisticated parties. Yet many investors conflate ETNs and ETFs. Where ETN investors should fear what they don’t know, they instead are gulled into thinking that they understand the risks and costs they bear.

The investment banks take full advantage of their superior sophistication. From the get-go, the ETN is a fantastic deal for banks. It’s in the DNA of the product; once held, an ETN almost can’t help but be fabulously profitable to its issuer. Why? They’re dirt-cheap to run because the fixed costs are already borne by infrastructure set up for structured products desks. They’re an extremely cheap source of funding, the life blood of the modern bank. More important, this funding becomes more valuable the bleaker an investment bank’s health. As a cherry on top, investors get to pay hefty fees for the privilege of offering this benefit to banks.

And even this isn’t enough for some issuers. They’ve inserted egregious features in the terms of many ETNs. The worst we’ve identified so far is a fee calculation that secretly shifts even more risk to investors, earning banks fatter margins when their ETNs suddenly drop in value.

Kicking You When You’re Down
The first ETNs, iPath DJ-UBS Commodity Index DJP and iPath S&P GSCI Total Return Index GSP, set a disturbing standard: path-dependent fees. This type of fee creates tracking error to the index depending on the index’s path. In contrast, mutual funds charge path-indifferent fees, which result in a constant percentage gap between an index fund and its benchmark.

To see the difference between these two fee structures, let’s look at how fees contribute to tracking error of an index mutual fund, Vanguard 500 Index VFINX, and the iPath DJ-UBS Commodity Index ETN.

The first chart in the exhibit shows the cumulative daily percentage difference in 2011 between Vanguard 500 Index and the S&P 500, its benchmark. It’s nearly a straight line, showing that each day the fund lagged the S&P 500 by roughly an equal percentage. By the end of the year, the fund lagged its benchmark by only 0.14%— a hair under Vanguard 500 Index’s stated expense ratio of 0.17%. Like many Vanguard index funds, it lagged by less than its fees because of income-generating opportunities such as securities lending and futures arbitrage.

Compare that with the second chart, which shows the iPath ETN’s cumulative tracking error over the same period. This chart is based on the ETN’s indicative value (the ETN analog of the net asset value). If the ETN’s annual “investor fee” of 0.75% behaved like an expense ratio, we’d see a smooth, upwardtrending line terminating at about 0.75%. Instead, the ETN lagged its benchmark by 1.27%. Note how its fees spiked most when the commodity index dropped the hardest, during the tumultuous fourth quarter.

This is the genius of the path-dependent fee calculation: When the path of the underlying index drops, the investor’s tracking error to the index widens, to the investment bank’s benefit.

The iPath ETN’s performance during the financial crisis is also informative. From the index’s July 7, 2008, peak to its March 2, 2009, nadir, the index returned negative 56.9%. The ETN’s indicative value returned negative 57.9%. Geometrically, the ETN lagged its index by 2.3 percentage points (simply subtracting one percentage from another isn’t mathematically kosher). Investors were slammed with extra losses at the worst time possible. The issuer, Barclays, earned the spread between its costs of hedging the index and the ETN’s 2.3 percentage-point-lag against the index during the financial crisis. This spread was extremely valuable to Barclays because it was a source of positive returns during extreme down markets.

To get a sense of how valuable this kind of insurance can be, consider how much investors pay to hedge bear markets. The Chicago Board Options Exchange Market Volatility Index, or VIX, is often called the fear index. The cost of rolling VIX futures is one proxy for the insurance premium the market demands for bearing this risk. As of the end of May, the S&P 500 VIX Short-Term Futures Excess Return Index lagged the VIX by nearly 30% annualized over the past five years. If investors are going to bear additional downmarket risk in their ETNs, both theory and the market say they should be handsomely compensated.

Why did iPath DJ-UBS Commodity Index behave like it did? It’s all stated in the prospectus, cloaked in a curious blend of legalese and math. In short, fees are subtracted every day from a “shadow NAV” based on the ETN’s before-fee performance since inception. The ETN’s indicative value (the price investors get) is simply the result of subtracting all the accumulated fees from the shadow NAV. This means investors are fully exposed to losses (and gains) of the underlying index, as well as the accumulated fees.

Here’s an extreme example to make things concrete: Let’s say an ETN’s shadow NAV is $100 and accumulated fees $20, so the ETN’s price is $80. The index tanks 50%, halving the shadow NAV to $50. Because the ETN’s price equals shadow NAV minus accumulated fees, the ETN’s price is now $30. The investor would experience a drop from $80 to $30, a 62.5% drop, far more than the index’s 50% fall.

But don’t take my word for it. The iPath ETN’s prospectus helpfully shows four hypothetical price paths the ETN can take and how much it can lag the index. In one, over 30 years, the return of the index is negative 2.37% annualized; the ETN, negative 8.54% annualized, a truly apocalyptic result. But as the financial crisis showed, the kinds of sharp drops that generate big lags aren’t impossible.

Granted, the calculation of path-dependent fees can favor investors during sharp rebounds. In the most extreme scenario, the investment bank’s fee approaches zero. However, such a benefit is poor consolation for investors. The unpredictable tracking error caused by path-dependent fees negates the argument that ETNs are able to offer investors perfect tracking of the index. Then, there are the terrible timing of losses and the asymmetrical payoff structure—issuers can tightly cap their losses, while investors can be exposed to huge losses.

Fee Smorgasbord Path-dependent fees only scratch the surface of the investor unfriendliness of some ETNs. There are plenty of other examples.

UBS’ ETRACS short VIX ETNs (AAVX, BBVX, and so on) charge a 4.004% annual levy on top of its 1.35% investor fee to cover “event risk hedge costs.”

Barclays’ iPath Pure Beta Commodity ETNs (BCM, and so on) levy a 0.10% fee for “futures execution costs.”

Credit Suisse’s Liquid Beta ETNs (CSLS, CSMA, and so on) subtract 0.50% out of the index (so it’s not even included in its regular fee calculations) and calls it an “index calculation fee.”

When many players in the industry behave in ways that signal they can’t be trusted, it raises questions about all ETNs. What a shame. The best ETNs can be truly useful tools, fulfilling their promise of tax efficiency and perfect tracking.

The ETN industry has gotten away with such investor-unfriendly behavior by free-riding the goodwill that conventional ETFs have created as simple, low-cost, transparent, tax-efficient products. Understandably, many investors have taken for granted that the ETNs’ headline fees are calculated just like expense ratios and that “gotcha” fees are not facts of life. Making that assumption is a lot easier than combing through hundreds of pages of a prospectus.

Given how publicly accessible ETNs are, buying one should not be an exercise in legal minesweeping. Until this situation changes, caveat emptor.

Samuel Lee is an ETF Analyst with Morningstar.

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